The IRS uses a multi-factor test to determine whether a worker is an employee or an independent contractor. The three primary categories of factors are behavioral control, which assesses whether the business controls how the work is done rather than just the result; financial control, which assesses whether the worker has a significant investment in their tools, has the opportunity for profit or loss, and works for multiple clients; and type of relationship, which considers whether there is a written contract, employee benefits, and the permanency of the relationship. No single factor is determinative, but the pattern across all factors indicates the correct classification.
The practical distinction is meaningful. Workers who are told when, where, and how to do their work, who use equipment provided by the business, who work exclusively for one company over an extended period, and who are integrated into the core operations of the business are employees. Workers who set their own hours, use their own tools and equipment, work for multiple clients simultaneously, are engaged for a specific project with a defined end date, and have a distinct trade or profession separate from the business they are serving are contractors.
Misclassifying an employee as a contractor exposes your business to back payroll taxes, employer share of Social Security and Medicare, unpaid unemployment insurance contributions, and potential penalties for failure to withhold and remit those taxes. The IRS can assess these liabilities for all prior years in which the worker was misclassified, plus interest and penalties. State labor agencies can add additional penalties for violations of state wage and hour laws, workers' compensation requirements, and unemployment insurance obligations.
California operates under a stricter classification standard than the federal standard: Assembly Bill 5 created the ABC test, which presumes all workers are employees unless they satisfy all three of specific conditions including that the work performed is outside the usual course of the hiring entity's business. This standard has significant implications for businesses that rely heavily on contract labor. If you have workers in California, consult with an employment attorney about your classification practices before assuming federal standards apply.
If you are uncertain about how to classify a specific worker relationship, there are two safe options. You can file IRS Form SS-8, which requests an IRS determination of the worker's status. The process takes several months but provides a definitive answer from the authority that will ultimately make the determination if you are ever audited. Alternatively, you can consult with an employment attorney before the engagement begins rather than after it has been established in a way that may prove difficult to reclassify.
The classification question is most important to get right at the beginning of each worker relationship, because the pattern of behavior over the first weeks and months of an engagement establishes the nature of the relationship in ways that are difficult to change retroactively without creating additional risk.